This Is the Real Danger of the Irrational Exuberance Surrounding Bitcoins

If you're anything of a long-term investor, someone who's studied economics, or simply a fan of finance, you've probably looked on with disdain as the electronic currency known as Bitcoins has exploded from just $20 per fictitious token to a high of $266 in less than two months.

Source: Casascius, wikimedia.commons

The currency, if it can even be called that, was described in good detail by my colleague Alex Planes earlier this week. Its value is derived not from any sort of monetary backing -- no government or monetary body recognizes a Bitcoin as an acceptable form of currency -- but from the acceptance of other retailers and individuals who are willing to assign a monetary value to a Bitcoin and use that figure to exchange goods and services. Its value is also derived from its designed scarcity -- there are only a fixed amount of bitcoins to go around.

As you might have assumed, as someone with a penchant for thinking long-term and having studied economics in college, I think there's a clear and present danger investing in something that essentially doesn't exist beyond cyberspace. However, the truly scary part of Bitcoins isn't that they aren't backed by a government entity, but is ingrained in the fact that it's spawning a new generation of emotional and irrational investors who will get the completely wrong impression of how "investing" works.

History tends to repeat itselfYou may have come across the phrase that history tends to repeat itself; I believe this is a perfect case in point to describe the trading action in Bitcoins over the past six months.

In 1999 you could throw a dart at the newspaper, purchase the stock your dart landed on, and probably have come out a winner. Earnings, cash flow, and valuation were all placed on the back burner as the emergence of the Internet as a commerce medium was putting all of those "archaic" investment tools back in the box. The technology-driven Nasdaq Composite would eventually cross 5,000, and both Cisco Systems and Microsoft would top $500 billion in market value. Near their peaks, Cisco traded for around 120 times earnings, while Microsoft was valued at a multiple of 55. It was truly a time of emotional and irrational investing, and Wall Street encouraged it just as much as speculative traders promoted it.

This week, I came across an article from the Silicon Valley Business Journal dated March 19, 2000, just nine days after the Nasdaq's all-time record close. In that article, it's stated that 37 investment banks at the time had "strong buy" or "buy" rating on Cisco without a single "sell" or even "hold" rating. Furthermore, George Kelly, a Wall Street analyst who was working for Morgan Stanley Dean Witter at the time and was a player in bringing Cisco public in 1990, was quoted as saying in his defense of Cisco's enormous P/E multiple: "A low P/E usually signals investors are uncomfortable." Imagine that! Paul Weinstein, a founding partner of Azure Capital Partners and an analyst with Credit Suisse First Boston at the time, would make the bold claim that "Cisco could be the first trillion-dollar market cap company ... within two to three years."

Needless to say, most predictions fizzled out, with Cisco's $557 billion market cap now being worth about $115 billion, Microsoft down to just $241 billion, and the Nasdaq Composite still more than 1,700 points from an all-time high.

This week, we witnessed the complete collapse of Bitcoin euphoria as well, with the cyber-currency falling from its $266 peak to as low as $54 as of this writing.

What went wrong?What went wrong in both cases is that there wasn't any substance to back up speculators' euphoria, and once everyone realized that nothing more than hope was buoying stocks and Bitcoins, both bubbles began to collapse in epic fashion.

The Internet bubble of 2000 wiped out trillions in market value and bankrupted companies that previously had carried market values in the tens of billions. The Bitcoin bubble clearly won't have the same trillion-dollar effect on the economy, but it still could have a notable ripple effect on the pocketbooks of Tyler and Cameron Winklevoss, who've collectively invested about $11 million in Bitcoins. The brothers may have made it a point to avoid investing in something backed by the U.S. dollar, which they see as controlled by politics, but inadvertently chose to throw $11 million into a non-physical currency that pits emotional traders against one another with no tangible price drivers other than greed and hope.

History will keep repeating itselfThe worst part about Bitcoins and the Internet bubble of 2000 is that it will perpetuate the get-rich-quick mentality and ensure that another bout of irrational exuberance and emotional trading will occur in the future.

A more recent example is the debut of social-media powerhouse Facebook , which tipped the scales with a $100 billion valuation in the secondary markets before its IPO. Investors had placed a valuation of nearly 100 times sales on the company based on the assumption that it would grow into the next Internet powerhouse. The problem, as I described in August shortly after its IPO, is that investors are poor judges of disruptive technologies. It isn't that we can't recognize a great idea when we see one; it's that we assume it'll be a success almost immediately.

The same can be said for Bitcoin. It'd be wrong of me to assume it has absolutely no chance of being a viable currency medium over the long run, but speculators' opinions that this is the greatest thing since sliced bread probably has no bearing, either, since there are no tangible price-driving factors that would make the currency move higher outside of greed and hope. And the last time I checked, greed and hope weren't investing strategies -- not even by Gordon Gekko's standards anymore! (Link opens a YouTube video.)

The sad reality is that the Bitcoin bubble will create a new generation of traders that have no real understanding of how the market truly works. Don't get me wrong; the stock market is only as rational and efficient as the investors and brokerages behind those trades. However, the effectiveness of the stock market is a far cry from an emotionally driven, non-tangible, hope- and greed-based cyber-currency that is the Bitcoin.

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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool owns shares of Facebook and Microsoft and recommends Cisco Systems and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.